A QUICK LOOK AT…

AIA is publishing a series of articles designed to take a quick look at key topics in accountancy, management and finance. Bookmark this page to update your knowledge when you can grab a spare five minutes. If you would like to suggest subjects for future articles, please contact us.

A QUICK LOOK AT... FINANCING A BUSINESS

There are essentially only two ways of financing a business. Either the owner invests his or her capital (including the retaining of profits within the business); or the capital is borrowed from a third party and must, sooner or later, be repaid. Those in control of a business need to decide what proportion of each type of financing is best in any particular circumstance.

In practice, business owners may not have much choice. Start-up businesses will inevitably need an amount of owner’s capital in order to get off the ground. Lenders will often refuse to lend, or seek excessive interest rates, if they think the risk of lending to a particular business is too great.

If a business id fortunate enough to have a choice of funding sources how do they decide between or amongst the different possibilities? The following are some considerations:

Control: If capital is raised from any source except the existing shareholders the balance of control in the business will be altered. Effectively, the existing owners will surrender some of their current control.

Cost: The cost of borrowing, although possibly complicated to calculate, is usually capable of being known with precision. The costs of owner’s equity, on the other hand, can only ever be approximated. In most jurisdictions, the allowability of interest in the calculation of income or corporation tax means that, in normal circumstances, the cost of borrowing is less than the cost of equity. There are several academic theories most of which suggest that introducing some borrowing into the capital structure of a business will initially lower the cost of capital but the cost of capital will rise again if there “too much” borrowing. There is, unfortunately, no simple answer to the question “how much is too much?”

Risk: Borrowing is more risky than raising owners’ equity since if it cannot be repaid the lender will invariably have some sanction over the business. The ultimate sanction is to take over some of the assets of the business (e.g. foreclosing on a mortgage) or even forcing the business into bankruptcy or liquidation.